Investment Grade Bonds Are A Great Opportunity

The recent spread widening between Investment Grade bonds and the U.S. Treasury curve has been significant and may present a compelling buying opportunity for high quality IG bonds. Year to date, U.S. corporate bonds rated AA have compiled a total return of 1.13% while those rated BBB have returned -0.22%. Due to recent market volatility, a continued search for havens and the recent changes in spreads, IG bonds look attractive.

As noted in the black line in the above chart, the average spread between U.S. Treasuries and bonds has moved massively higher since September of 2015*. By and large, that move higher has been a repricing of the Treasury curve (flattening) as bond market participants try to ascertain the effects of changing monetary policy.

The current spread between IG bonds and Treasuries is pricing in an extremely negative outcome. At roughly 200 basis points above the Treasuries, IG bonds are either an attractive asset class or a very large canary in the dungeon of a coal mine that will presage a global recession.

If IG bonds are a decent buying opportunity (properly sized and risk-managed and at longer maturities), it is due to the compression of the U.S. Treasury curve. That is, the reason for the spread widening between bonds and Treasuries is because of curve flattening, not because IG bonds now contain an embedded, previously unknown, asset class risk.

The global economy and related risk assets are quite a frightful duo so far in 2016. There is no doubt that the global economy is weak. There may also be problems with monetary policy experimentations, high asset price values, and fiscal incompetency. However, the truth remains that the U.S. economy is hanging on so far. It is an economy that is far from burgeoning, but jobs are being created, the banking system is mostly repaired, consumers are less levered, and policy makers are at least aware of domestic and global stresses.

The U.S. Treasury curve has been pancaked since the beginning of the year. Investors have focused on short term price volatility as a risk more than an opportunity to reprice favored assets. Some of that volatility has been derived from a suspicion of a “policy mistake” by the Federal Reserve. The question lingers whether the Fed raised interest rates at the wrong time (too late) and in the face of deteriorating global conditions (e.g., China, oil prices). In essence, there is a palpable fear that the Fed’s concern should have been deflationary pressures, not a dogmatic belief in an institutional forecasting ability (the “dot plot”).

In assessing the overall health of the IG bond market, remember that professional credit traders tend to trade spread rather than mere coupon (yield) – either directly or as the result of hedges. For many institutions, a long position in IG bonds at these spread levels is about liquidity, overall portfolio management and exposures and a further play on the yield curve. Many institutions will optimize individual trades and portfolios for positive carry as well when possible.

For the retail crowd looking at IG bonds, there should be less day-to-day obsession over the slope of the U.S. Treasury curve. Bonds rated AA are currently yielding 2.5% while those rated BBB are yielding 4.35%. For example, the
Anheuser-Busch InBev 2026 bond is currently yielding 3.4% while the
Visa 2025 bond is yielding 2.85%. Neither of those bonds present a poor return when sized correctly, ensuring liquidity and when compared to the risk embedded in other credit assets like high yield bonds.**

Ultimately, one of two scenarios is likely to happen and which will affect IG bond returns and risks. The first scenario is that the U.S. yield curve continues to flatten. Absent an inverted curve or a complete global recession with fast moving transmission mechanisms, select, longer maturity IG bonds may do well in an environment of a slowly flattening curve. It is clear that there is a continued chase for yield and IG corporate credits are currently paying coupons that are good risk-to-rewards in many situations.

The second situation is that the U.S. yield curve rises (with or without kinks in the belly) as the fed funds rate rises faster than the market currently forecasts. Why would that happen? It would happen, because the U.S. economy show signs of being less doomed than the naysayers are currently forecasting. This is what Pimco refers to as the “new neutral” type of economy – slow and steady growth (e.g., GDP of 2.0%) with some volatility along the way. This scenario would put some duration risk into play for IG bonds, but the most likely change in the U.S. Treasury curve would be a sharper front end rather than previous conceptions of a much higher “terminal rate” at the longer end. That fact should lessen IG bond risks.

Should the market be correct and the Fed only raises rates once (or twice) in 2016, the curve may flatten, but holding a liquid, longer maturity, IG bond is not likely to result in disaster. In a world that is still chasing yield, that could be a good risk-to-reward. Holding IG bonds may look like a good trade away from broader market volatility, fears of negative rates and deflation, and the apoplectic crowd that hates (and probably misunderstands) bonds and their return profiles.

DISCLAIMER: THIS IS NOT INVESTMENT ADVICE. THIS IS FOR ENTERTAINMENT PURPOSES ONLY.